Making Sense of Corporate Tax Changes

By: Nicholas J. Podsiadly, Deputy General Counsel, Regulatory Strategy and Public Policy, Jeffrey Korzenik, Chief Investment Strategist, and Al Cliffel, Corporate Tax Director. 

The Tax Cuts and Jobs Act of 2017 is the most significant retooling of the U.S. tax code in more than three decades. This is particularly true at the corporate level, where the thrust of the new code is to help U.S. companies be more competitive globally.

On the whole, U.S. companies stand to benefit immensely from the changes, and that could ultimately contribute to an uptick in overall economic growth. That said, tax reform isn’t an unadulterated cost-free benefit. The tax savings come with some tradeoffs, including new limitations on interest deductions and foreign income.

Here are four key areas where the impact of the law—now in effect—will be felt:

1. Corporate Tax Rates: For companies operating as corporations paying the highest statutory tax rate of 35 percent under the previous tax code, the reduction to 21 percent is significant to say the least. Additionally, the repeal of the corporate alternative minimum tax (AMT) further improves the tax outlook for some companies. Finally, certain pass-thru businesses operating as S corporations and partnerships, will benefit from lower marginal individual income tax rates and a new 20 percent deduction for qualified business income.

2. Capital Expenditures: Companies that make significant capital investments—such as for equipment and technology—are poised to benefit immediately from a change in how capital expenditures (capex) is deducted. Under the previous law, capex was expensed over an investment’s applicable life with a 50 percent bonus depreciation available for the first year. Under the new law, companies can expense 100 percent of the cost of qualified property, for five years.
It’s important to note that this provision is currently slated to phase down after 2022—though lawmakers may try to extend it if an increase in capex boosts productivity, a key ingredient for economic growth.

3. Interest Deduction: One of the more complex changes to the law relates to interest deductibility. Previously, companies could deduct interest costs as they were incurred with no limitations. For most large taxpayers, the new law caps interest deductibility at 30 percent of adjusted taxable income, which is based on earnings before interest, taxes, depreciation and amortization (EBITDA) through 2021. After that point adjusted taxable income will be based on earnings before interest and taxes (EBIT).

Viewing this change through the lens of credit quality, most investment-grade issuers and approximately 75 percent of high-yield issuers likely won’t be impacted: The benefits of a corporate tax rate reduction and upfront capex deductibility should outweigh any reduction in interest deductibility

The outlook for the most highly-leveraged companies, however, isn’t quite as upbeat. Among companies with five times more debt than income, nearly 70 percent are expected to be negatively impacted from the loss of deductibility.

The phase-out of upfront deductibility of capital spending after five years, moreover, could make matters worse for these companies.

4. Repatriation Tax: A key aspect of the new tax code is how the U.S. taxes international income.

Previously, U.S. taxes on foreign profits could be deferred until companies repatriated those profits back to the U.S.

Under the new law, any U.S. shareholder of any controlled foreign corporation that is at least 10-percent owned by a U.S. corporation will owe taxes on accumulated post-1986 non-U.S. earnings.

Whether or not a given company brings home its earnings, it will be taxed at a “Transition Tax” rate of 15.5 percent for earnings held in cash and cash equivalents as well as 8 percent on earnings held in other assets. These tax liabilities will be charged to 2017 earnings and payable in installments over an eight-year period.

Benefits, Yes, But Challenges, Too

Certain industries will be positioned to gain from tax reform because of the nature of their business model.

Technology, for example, will likely benefit from the low repatriation tax given large amounts of offshore money these companies hold. Assuming that tech companies bring home their foreign assets, this could pave the way for increased capital expenditures, share buybacks, and dividend increases.

Airlines, automotive companies, industrials, and paper and packaging companies could also come out ahead, as these capital-intensive industries could benefit from immediate capex deductions, not to mention a decrease in the corporate tax rate.

That said, the new law will no doubt present challenges for some industries, particularly those with high leverage, low capital expenditures, existing low rates, and those that choose to keep revenue off-shore.

Telecom and energy, for example, are both sectors characterized by high net-operating losses. The same may be true for healthcare, where above-average leveraged-buyout activity has driven up debt levels to the point that some highly-leveraged companies could be hit by a double-whammy of rising interest rates and higher tax burdens.

Further, the new tax law will likely serve as a catalyst for corporate debt restructuring as well as an uptick in mergers and acquisitions.

Even so, just as individuals and families will need to adjust their individual tax strategies given the changes to the tax code, companies will need to balance the best strategy for the updated tax code. At the same time, while many of the corporate tax provisions are permanent, compared to the individual tax code changes, many provisions in the new law are slated to sunset and shifting political winds could add another element of uncertainty. Further, companies will need to give careful consideration to how they choose to utilize any savings achieved as a result of the politically polarized views on the Tax Cuts and Jobs Act.   

(1) Incorporates the net impact of the limitation on interest deductibility, a lower corporate tax rate, and the ability to fully deduct capex. The percentages are derived as an issuer count. Worse off is defined as having a higher tax bill as a result of limitations on interest deductibility

(2) Based on three-year average forecasted data as of 12/1/2017; reported operating income before depreciation and amortization used as proxy for EBITDA

This article was written by Fifth Third Bank.

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